How Will a U.S. Fed Interest Rate Hike Impact Oil Prices?

Update: The Federal Reserve raised rates on December 16th from 0 to .25 percent, suggesting that while the era of zero interest rates has ended, the era of low interest rates will continue for some time. The rate hike, however small, adds another mildly bearish element to the global crude market by strengthening the dollar. See our piece below from August 2015 for more details.

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The financial world is eagerly anticipating the U.S. Federal Reserve meeting in September, in the expectation that the central bank may finally raise interest rates for the first time in about eight years. The oil markets will be keeping a close eye on any developments, too, as any rate hike could push prices even lower from current levels of $40 for WTI and $47 for Brent. But the impact may be mild and short term given that the Fed has telegraphed the rate hike for some time. In fact, higher interests could ultimately be bullish for oil and other commodities in the longer term as producers would be negatively impacted.

It’s unclear if the Fed will definitely raise rates in September, as many economists have predicted, but the central bank said in minutes from its July meeting, released Wednesday, that participants “judged that the conditions for policy firming had not yet been achieved, but they noted that conditions were approaching that point.”

If crude oil market physical fundamentals hold steady with supply well ahead of demand, as most analysts expect, prices would take a hit from any strength in the dollar that resulted from an increase in interest rates.

“The upcoming Fed exit from zero policy rates may have an impact on oil, energy and commodity prices,” Nouriel Roubini, chairman of Roubini Global Economics, told The Fuse. “It will lead to further U.S. dollar appreciation that tends to reduce the dollar price of commodities. It will trigger some economic and financial volatility in emerging markets that‎ may be a negative for commodity prices. It will lead to a rise in the dollar cost of borrowing that tends to weaken commodities that are financialized.”

Nouriel Roubini: “The net effect of all these channels is likely to be a modest negative for many commodity prices.”

Roubini added: “But if an exit from zero policy rates is also driven by stronger U.S. growth that helps global growth it may generate more demand for commodities that will have a positive impact on their prices. So the net effect of all these channels is likely to be a modest negative for many commodity prices.”

The stronger dollar, which has been on a bull run for slightly more than a year and has gained roughly 20 percent versus a basket of currencies in that time, has contributed to the steep fall in oil prices over the past 14 months—along with weaker-than-expected demand, rising U.S. production, and OPEC pumping close to all out.

“A stronger dollar does cause headwinds for economically sensitive commodities like oil,” said Jodie Gunzberg, Global Head of Commodities at S&P Dow Jones Indices. “But it hurts oil a lot less than other factors such as continued oversupply from OPEC and the U.S. and excess inventories.”

Commodities have, in fact, suffered this year, thanks to a mix of weak fundamentals and the dollar’s strength. The S&P GSCI, a basket of 24 commodities, has seen total returns of minus 18 percent year-to-date, with U.S. crude oil’s losses at an abysmal 30 percent. Precious metals, which include gold and silver, have been the best performers but have still suffered returns of minus 6 percent. By contrast, the S&P 500 has seen returns of about 1.6 percent this year.

The dollar is closely linked to the oil market for two key reasons.

The dollar is closely linked to the oil market for two key reasons. For one, with oil priced in the U.S. dollar, fluctuations in the greenback affect purchasing power for importing countries and, at the same time, impact revenues for exporters. But more critically, with the currency and commodity markets interconnected, a stronger dollar typically prompts speculative traders to sell oil futures and other commodities and buy more of the U.S. currency. The inverse correlation between the dollar and oil prices has been at a relatively high 60-70 percent over the past ten years, meaning the oil market and the dollar are indeed connected—but not too closely. The link is not as tight as the oil price and the S&P 500 were from 2009-13, when the correlation between the two markets hit at a very high 90 percent.

Hedge funds get bearish

Any further selling as a result of a stronger dollar could prompt another leg downward, or at least keep prices “lower for longer” before the market turns around and hedge funds add more long positions.

Hedge funds and other speculators do not need any more reasons to remain bearish when it comes to oil prices, but any Fed action—whether it comes in September or later in the year—would provide motivation to sell further and possibly pull prices down, say some oil market analysts. Liquidation among these noncommercial players accelerated the price move downward over the past 14 months. Any further selling as a result of a stronger dollar could prompt another leg downward, or at least keep prices “lower for longer” before the market turns around and hedge funds add more long positions. Speculative investors have turned considerably bearish since the middle of last year and even more so since April of this year. Net length in NYMEX crude futures—the number of contracts betting on higher prices—now stands around 104,000 contracts, the equivalent of 104 million barrels of oil. That level is down sharply from just under 300,000 contracts in April and about 400,000 in June of last year, when prices peaked for 2014.

Quantitative easing is done, in the U.S.

While the Fed’s action would be a negative for oil prices in the U.S., the central bank’s stimulus action of buying government bonds—aka quantitative easing (QE)—taken up during the financial crisis of 2008 was a major factor in lifting oil prices from the $30-$40 range to over $100. QE, which had three phases and ended for good in October of last year, inflated all asset classes and weakened the U.S. dollar, trends that provided speculative investors with motivation to bet on higher oil prices.

But the unwinding of the QE program at the same time that central banks have taken measures in Europe and China to stimulate their economies have provided the extra support to the U.S. dollar. With a U.S. interest rate around the corner, high debt levels in Europe remaining for the foreseeable future, and China devaluing its currency, the yuan, the dollar’s strength ought to remain further intact. These signals are bearish for oil.

While Fed action may cause knee-jerk selling in the oil market, higher interest rates are historically bullish for commodities. For instance, during rate hikes from 2004-2007, the S&P GSCI saw stellar returns of 27 percent. Higher interest rates can negatively impact the incentive to hold supply in storage, a key factor in commodity pricing. Simply put, higher interest rates make it more expensive to hold storage. The less crude being held in inventory, the tighter the market. Right now, as the crude futures curves are in contango, with prompt prices lower than deferred contracts, there is a strong financial incentive to store oil, which is keeping inventories high.

“The opportunity cost is higher from the forgone interest so the incentive to store diminishes,” said S&P’s Gunzberg. “Not only does the incentive to store diminish, but the rising rates may motivate investors to shift investments from commodities to yield-generating capital assets.”

If investors flee the oil futures market, liquidity could dry up with open interest collapsing. In this environment, producers would pull back and draw down inventories. These developments, if realized, would ultimately lift oil prices.

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The Fuse is an energy news and analysis site supported by Securing America’s Future Energy. The views expressed here are those of individual contributors and do not necessarily represent the views of the organization.

Issues in Focus

Safety Standards for Crude-By-Rail Shipments

A series of accidents in North America in recent years have raised concerns regarding rail shipments of crude oil. Fatal accidents in Lynchburg, Virginia, Lac-Megantic, Quebec, Fayette County, West Virginia, and (most recently) Culbertson, Montana have prompted public outcry and regulatory scrutiny.

2014 saw an all-time record of 144 oil train incidents in the U.S.—up from just one in 2009—causing a total of more than $7 million in damage.

The spate of crude-by-rail accidents has emerged from the confluence of three factors. First is the massive increase in oil movements by rail, which has increased more than three-fold since 2010. Second is the inadequate safety features of DOT-111 cars, particularly those constructed prior to 2011, which account for roughly 70 percent of tank cars on U.S. railroads. Third is the high volatility of oil produced from the Bakken and other shale formations, which makes this crude more prone towards combustion.

Of these three, rail car safety standards is the factor over which regulators can exert the most control. After months of regulatory review, on May 1, 2015, the White House and the Department of Transportation unveiled the new safety standards. The announcement also coincided with new tank car standards in Canada—a critical move, since many crude by rail shipments cross the U.S.-Canadian border. In the words DOT, the new rule:

Since the rule was announced, Republicans in Congress sought to roll back the provision calling for an advanced breaking system, following concerns from the rail industry that such an upgrade would be unnecessary and could cost billions of dollars. The advanced braking systems are required to be in place by 2021.

Democrats in Congress have argued that the new rules are insufficient to mitigate the danger. Senator Maria Cantwell (D-WA) and Senator Tammy Baldwin (D-WI) both issued statements arguing that the rules were insufficient and the timelines for safety improvements were too long.

The current industry standard car, the CPC-1232, came into usage in October 2011. These cars have half inch thick shells (marginally thicker than the DOT-111 7/16 inch shells) and advanced valves that are more resilient in the event of an accident. However, these newer cars were involved in the derailments and explosions in Virginia and West Virginia within the past year, raising questions about the validity of replacing only the DOT-111s manufactured before 2011.

Before the rule was finalized, early reports indicated that the rule submitted to the White House by the Department of Transportation has proposed a two-stage phase-out of the current fleet of railcars, focusing first on the pre-2011 cars, then the current standard CPC-1232 cars. In the final rule, DOT mandated a more aggressive timeline for retrofitting the CPC-1232 cars, imposing a deadline of April 1, 2020 for non-jacketed cars.

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DataSpotlight

The recent oil production boom in the United States, while astounding, has created a misleading narrative that the United States is no longer dependent on oil imports. Reports of surging domestic production, calls for relaxation of the crude oil export ban, labels of “Saudi America,” and the recent collapse in oil prices have created a perception that the United States has more oil than it knows what to do with.

This view is misguided. While some forecasts project that the United States could become a self-sufficient oil producer within the next decade, this remains a distant prospect. According to the April 2015 Short Term Energy Outlook, total U.S. crude oil production averaged an estimated 9.3 million barrels per day in March, while total oil demand in the country is over 19 million barrels per day.

This graphic helps illustrate the regional variations in crude oil supply and demand. North America, Europe, and Asia all run significant production deficits, with the Middle East, Africa, Latin America, and Former Soviet Union are global engines of crude oil supply.